Look for These Key Factors Before Buying a “Cheap” Stock

Over the last few days, I’ve been sharing essays from Bonner Private Portfolio editor Chris Mayer, who will join me at the Legends of Finance Summit next Thursday.

The reason is simple: Chris is one of the best value investors on the planet. And he has one of the best track records in our business.

Using his proprietary investment strategy, Chris outperformed the S&P 500… legendary investors like Carl Icahn, John Paulson, and David Einhorn… and even Warren Buffett’s Berkshire Hathaway for 10 years straight.

So I recently sat down with Chris to learn more about the strategy he uses to finds winners again and again.

As you’ll see, our investing styles have a lot in common. And there’s one key similarity you can use to build a fortune in any market…

Until next time,

Nick Giambruno Senior Editor, International Man

Nick Giambruno: Chris, thanks for joining me today.

Chris Mayer: My pleasure.

Nick Giambruno: I think we have similar investing strategies, albeit with a different twist.

My advisory Crisis Investing is all about buying quality companies in severely beaten up markets. I look for situations where everyone else has thrown in the towel – where the sellers are begging for a buyer.

Many of the world’s greatest investors made their fortunes this way, but anyone can do it. You don’t need to be rich or well-connected. You don’t even need to travel to do it.

In fact, if you have a regular brokerage account – and the courage to buy when others are fearful – you're all set. The courage part is key. You can't be a successful crisis investor if you're not willing to go against the crowd.

How does this compare to your investment philosophy and asset allocation strategy in Bonner Private Portfolio?

Chris Mayer: Nick, my approach is similar.

We’re both trying to profit from temporary distortions in the marketplace. We’re both taking advantage of the prices fear generates.

This is hard for most people to understand. They prefer to buy a stock when the news is good, when they read positive comments about a stock in the press, etc.

But it’s very hard to earn market-beating returns that way. Because that optimism comes at a price.

You and I like to play where there is some fear, because we get great prices. And great prices seed great returns.

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In this exclusive event, they'll discuss Bill's ambitious “Trade of the Century” – along with 6 different ways you can play it.

Nick Giambruno: That’s right, Chris. When there’s a crisis, most people only see danger. But danger often masks the best opportunities…

Crises distort the market. And these distortions often allow you to buy a dollar’s worth of assets for a dime or less. The key is to capitalize on that.

Chris Mayer: However, I focus on the companies, not so much where they are. That’s where we differ.

For example, in January 2017, I recommended Rolls-Royce in the UK. There was a lot of bad news about a big loss, a dividend cut and so on.

The market reacted badly and the stock plunged. But the loss was due to an accounting change. The core underlying business is actually a gem.

That stock is up 60% in less than year – and that’s a blue-chip asset, not a penny stock!

Nick Giambruno: That’s impressive. So how do you select individual stocks?

Chris Mayer: I have a system I sum up with the acronym CODE.

C is for cheap. We want a great price.

O is for owner-operator. We want to invest with people who have skin in the game.

D is for disclosures.We want businesses that make adequate disclosures with no red flags.

E is for excellent financial condition. We don’t want companies with a lot of debt.

These four factors work well together and make a great screen. It’s hard to find stocks that meet all four tests.

I know you have an entirely different set of things you look for, even though our overall approach is similar.

Nick Giambruno: You’re right. But before I get into my approach, let’s face up to a hard question that I often get, and I’m sure you do, too: How can you know the exact best time to buy? How can you be sure you’re at the moment of maximum pessimism?

The hard answer is: you can’t. At least not until after the fact. You’ll never recognize the exact bottom, except through the rearview mirror.

But you can recognize the signs that a market is near a bottom. That’s good enough to make you a lot of money.

With that in mind, here are some of the things I look for in crisis investments…

Negative investor sentiment/hated markets. Mass media is a big help here. A hot market – anything the financial media has fallen in love with – is exactly what I don’t want.

Instead, look for bad news about a market on the front page of the newspaper. The media is flashing a signal that most investors have thrown in the towel. And that’s when I like to buy.

Beaten-up markets.When a market falls to a low not seen in a decade or more, it’s worth a closer look.

Stocks.Are shares in great companies dropping almost as much as shares in junk companies? This is key. In a crisis, all stocks plunge – both good and bad. Extreme negativity can compress the prices of quality companies like a coiled spring.

I want to pay next to nothing for sound, productive, and well-run businesses that are earning money and paying dividends.

Dividends.I think dividends are the single best indicator of true value. Reported earnings can be unreliable. The right fictions can too easily pump them up. Accounting rules and fact-stretching can distort financial statements. But a dividend payment is cash in your pocket… and you can’t fake that.

Of course I analyze earnings, book value, and other reported market figures. But I pay special attention to dividends and their sustainability.

Chris, how do you determine the ideal entry point for an investment?

Chris Mayer: Well, as you said, it is a hard question.

I always love to see insiders buying stock. They know the company better than anyone. And when they come out of pocket to buy shares, you know they like what they see.

That’s probably my favorite indicator that now is a good time to buy.

I also like when a company announces the sale of a division. It may mean the company is about to get a cash windfall and get rid of a problem at the same time. The market can be slow to react to this.

But a lot of times the discount we’re getting is wide enough, it doesn’t much matter if we hit the exact bottom.

Nick Giambruno: Shifting gears a little bit, let’s talk about mean reversion. It’s a common theme in both of our strategies.

It’s based on the fact that nothing goes up forever. Sooner or later, even the mightiest bull markets get old and overvalued. Eventually, “gravity” causes the market’s momentum to slow, and then reverse.

When the market “reverts to the mean,” stocks plummet.

Every investor who lived through the 1987 market crash, Russia’s 1998 default, the Nasdaq decline of 2000-2002, or the mortgage meltdown of 2008 knows this. Every five to 10 years, something goes horribly wrong in the market.

But just like stocks don’t go up forever, they don’t go down forever, either.

Eventually, every bear market forms a bottom. The last person left to sell actually sells. A market sinks to such an amazing level of value that investors pile in and send share prices higher. And extreme bear markets turn into extreme bull markets. It’s a never-ending cycle.

Chris, how does mean reversion play into your strategy?

Chris Mayer: Yeah, you’re right. Markets overshoot. And undershoot. Thank goodness they do, or people like us would have nothing to do.

I’m careful about mean reversion, though. Just because a stock trades well below its average valuation doesn’t mean it’s cheap. The business might have changed for the worse.

Look at retailers. Lots of people lost a lot of money betting on mean reversions that never came. Amazon changed the landscape in retailing forever.

Nonetheless, when I find an asset that trades well outside its “normal” range, that gets me interested.

Sometimes whole sectors just fall out of favor for a while for whatever reason. And you can make a lot money playing the rebound.

Nick Giambruno: I agree. Thanks for your time today, Chris.

Chris Mayer: Thank you, Nick.

Nick Giambruno’s Note: On February 8 at 8 p.m. ET, Chris and I are joining Casey Research founder Doug Casey and Bonner & Partners chairman Bill Bonner for the first-ever Legends of Finance Summit.

During this historic free event, we’ll have a lot more to say about our strategies – how they’re similar, how they’re not, and some of the best ways to play both of them right now. Be sure to reserve your spot right here.